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The Weird Future and Weirder History of Life Insurance

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When we think of "innovative financial products," we probably think of credit-default swaps, collateralized debt obligations, and other ghoulish abstractions that we nervously half-remember from that last Michael Lewis book we read. We probably don't think of life insurance. But a fascinating new article in the New York Times Magazine gives a very informative tour through the "life-settlements business:" an emerging marketplace whereby people who need cash near what is ostensibly the end of their life sell their life insurance policies to a third party for a price.

Here's how it works: once a person decides to sell his/her life insurance policy, the third-party investor does a bunch of research, usually based on the the seller's medical records, to see how long the person is likely to live. (This is important, as the third party investor is on the hook to pay the sick/dying person's life insurance premiums until their death.) Then the seller and the investor agree on a price. Say we're talking about a $500,000 life insurance policy, and a person with a two-year life expectancy; the investor might offer $300,000, in hopes that the difference will both cover the cost of paying premiums for the rest of the seller's life and leave room for profit.

As ghoulish as this sounds, the article's writer, James Vlahos, makes the case that this is in fact a pro-consumer innovation in the life insurance marketplace. He may be right; I'm not sure. But what many commenters to the article really find ghoulish is the simple fact that we have such an eroded public safety net that folks are reduced to selling their life insurance policies for the sake of paying their medical bills and the other costs associated with old age. In an era of small social security payments, high medical costs, and a failed system of retirement savings, our once-proud system to prevent poverty in old age is reeling.

And indeed, what the life-settlements business really does is offer a way to convert "death insurance" into "old-age insurance"--which was, sure enough, an important private market back in the bad old days before social security.

In fact, there was one product back in the 19th and early 20th century that combined death insurance (probably a more apt term than life insurance, eh?) with old age insurance in one package. It was called the tontine; basically, a bunch of people would pay their life insurance premiums into a big pool, and that pool of money would pay dividends back to all of its members. As people died and fell out of the pool, their families got a life insurance payment, but the number of beneficiaries drawing from the pool shrank--and the dividends to each remaining member increased. As you aged, you got higher dividends. But there was a hitch: in many tontines, if you missed a single payment, you would fall out of the pool, and your equity would be divided among those who remained. Thus, to put it most dramatically, the old goat who outlived every other member of the pool would get the fattest dividends, and his family would get the biggest life insurance payout.

The tontine was outlawed in the early 20th Century, but variousscholars have called for some modified version of its return.

What can we draw from all this? That our social insurance safety net is in trouble: yes. That financial innovation in life insurance has a very long and weird history: absolutely.